The break-even point, an accounting and planning tool, refers to the point where the revenues of a business organization or its sales are equal to the expenses that the business has incurred in generating the aforementioned sales/revenues. Essentially, it is the point where a business enterprise does not incur a loss or make any profit. The break-even point is therefore a very significant tool for business managers since it shows the point which should not be exceeded if the business wants to make any profit. It is thus used to determine the lowest price at which the goods or services provided by a business organization have to be offered for the business to make profit.
As expected, the break-even point is also important in the setting up of margins for a business enterprise since the business must plan for its profit. This is due to the fact that the primary aim of any business organization is to be able to make profits. The break-even point is, therefore, instrumental in strategizing for net-profit calculations. The dynamics associated with break-even analysis are very critical in cases where managers wish to know the impact that their decisions have on the entire organization. As a result of break-even analysis, managers may use interventions like lowering the cost of purchases using bulk purchasing, abandoning expensive suppliers for new ones or even negotiating prices.
On the other hand, revenues can be increased by better customer services and value addition on products. An important point to note is that a strategy seeking to increase an organization’s profits by merely revising the margins is very risky. This is because customers will only purchase the same volume of goods after an increase in the price of the goods if the value of the goods has also been increased (Deal, 1999). Thus the customer is the ultimate determinant of the benefit of goods, the value that can be attached to the goods and also the volume of sales that a business enterprise will be able to make.
Differences between financial and Management accounting
There a number of differences between financial and managerial accounting. First of all, management accounts are used internally by the management of the organization. They are mostly used for decision making. On the other hand, financial accounts are mainly used by people who are not involved in the operations of the organizations. Some of the parties who use financial accounts include the government – for purposes of calculating taxes, shareholders, the public and even creditors, who may be interested in checking the liquidity of the organization. Companies are required by the law to prepare financial accounts every year, and thus financial accounts are mandatory while the preparation of management accounts is not a requirement. There is also a statutory requirement that financial accounts are audited by external auditors.
This is not the case with management accounts which may either be audited by internal auditors or left unaudited. Another difference between financial accounting and management accounting is the fact that financial accounting is governed by International Accounting Standards (Bushman, 2007). On the other hand, management accounting is not governed by international standards. Additionally, financial accounting is done using historical data while management accounting is done using both historical data and projections. Financial accounts are normally prepared after a given period of time, mostly a quarter a year, and according to legal provisions, after one year.
On the other hand, management accounts can be prepared any time as long as they are needed by the management. They are normally prepared by companies and organizations as they plan for the future, or as they plan to implement strategic innovations. Apart from the fact that management accounts are for internal use, managerial accounting is different from financial accounting in that its documents are confidential. On the other hand, financial accounts must be made available for use by various stakeholders. It is thus clear that, even though the two types of accounting are seemingly the same, they have a lot of differences.
Reasons why the level of profits/loss in the Profit and Loss Account does not correspond to increase/decrease in cash
The amount of profits made, or losses incurred by a business organization do not normally correspond with the increase or decrease in the cash of the organization. This is due to the dynamics of the operation of a business, which make some transactions be technically delayed, or even hold up cash somewhere. Let us have a look at some of the reasons why profits and losses reflected in the Profit and Loss Account may not be reflected by the amount of cash in possession of the business enterprise. It is usually the norm to charge depreciation in the Profit and Loss Account. This will indubitably lead to reduction in the amount of profit realized for a specific period, in comparison with the sales that a business enterprise has made in that specific period. Additionally, some debtors may clear their debts during the specific accounting period.
The debts cleared may belong to the previous period. This implies that, if the debtors at the end of the accounting period have reduced in comparison with debtors at the beginning of the accounting period, then the business organization will have more cash as compared to the sales it has made during the accounting period. The same case applies for creditors, whose increase at the end of the accounting period will lead to an increase in the cash the organization has, and vice versa.
The cash in an enterprise may also fail to reflect profits or losses made due to the dynamics of the inventory. If the inventory has increased during the accounting period, then cash has been held in the inventory and thus it will be less than the profit shown in the Profit and Loss Account. Other similar reasons for the discrepancy include purchase of equipments, inclusion of goodwill, etcetera.
Advantages and limitations of ratio analysis
Ratio analysis is an accounting method used in analysing financial statements. It has a number of advantages that include the fact that it gives reliable information showing the state of a business organization at a particular point in time. This information is very critical in decision making for both internal parties like managers, and external parties like creditors. This important information includes the business’ profitability, liquidity, stock turnover, and the like.
Ratios can also be used to compare performances of a business with that of its competitors in a bid to strategize for competitive advantage. The calculation of ratios is easy, and thus it is not as mind-boggling as the preparation of financial statements. Another advantage stems from the fact that the calculation of ratios is easy. Thus ratio analysis takes a relatively short time, and thus information from ratio analysis is availed to its users in a timely manner for decision making.
Despite the usefulness of ratio analysis in the determination of the performance of a company, it has a number of disadvantages. One of these disadvantages is the fact that the tools used in ratio analysis only have a quantitative component and therefore, they are not holistic per se. It is thus difficult to evaluate qualitative aspects using ratio analysis. Another disadvantage is the fact that ratios are subject to distortion in cases where there are significant changes in inflation.
Another disadvantage comes from the fact that ratio analysis relies on accounting data, and thus they will definitely give misleading results if the data used in calculating the ratios is erroneous. Another serious limitation of ratios is the fact that they cannot be used in forecasting because they are based on historical data. Ratio analysis may also be sabotaged by window dressing of accounting information, leading to false results being given to users of the information from the ratio analysis (Rudnicka, 2011).
Relevant costs are a concept that is related to managerial accounting. These types of costs can be defined as the costs whose amount depends on the decisions made by the management of a business enterprise. Thus if particular decisions made by the management of an organization affect a certain cost, it can be concluded that the costs are relevant. On the other hand, if some anticipated costs are to be incurred without regard of the decisions made by the management, the costs are can be regarded as irrelevant. These types of costs are known as committed costs – future irrelevant costs.
One criterion that can be used to determine if the future costs to be incurred by an organization are relevant is by comparing the effect of certain alternatives on the amount of the cost. Relevant costs will always have significant differences in amount when different alternatives are considered. Identification of the types of costs in managerial accounting is an issue of great importance. This is because it may substantially affect the complexity of the analysis being done before making a decision. For instance, when a person is deciding between two models of cars, and the insurance is constant regardless of the model of the car bought, a consideration of the insurance during the decision making process will only serve to complicate the analysis. It is thus of essence that the management considers only relevant costs when making decisions (Caplan, 2007).
Bushman, M. (2007). The Differences Between Financial Accounting and Management Accounting. Web.
Deal, J. (1999). The Break-Even Point and the Break-Even Margin. Web.
Caplan, D. (2007). Management Accounting: Concepts and Techniques. Web.
Rudnicka, L. (2011). Limitations of Financial Ratio Analysis. Web.